Is a Roth IRA Right for You?

1. Introduction

The Taxpayer Relief Act of 1997 created a new type of individual retirement account (IRA) called the Roth IRA. Individuals are eligible to make contributions to a Roth IRA starting in 1998.

The key benefits of a Roth IRA, as compared to a regular IRA, are that any future distributions (including, most importantly, distributions of earnings) will not be taxable; the IRA owner doesn't have to start taking distributions after reaching age 70-1/2; and an individual can continue to make contributions to a Roth IRA after age 70-1/2.

The key drawbacks are that contributions to a Roth IRA are always nondeductible in computing the contributor's adjusted gross income (AGI) and that qualified distributions cannot be made until 5 tax years have elapsed.

This article discusses the Roth IRA rules including eligibility to make contributions, the maximum amount that can be contributed, rollovers from regular IRAs, and the conditions that must be met for distributions to be tax-free.

The article also discusses how to determine whether a particular taxpayer will benefit more from making contributions to a Roth IRA or a regular IRA, whether a taxpayer should roll over (or convert) a regular IRA to a Roth IRA, and steps a taxpayer can take to lower AGI so as to be eligible to contribute to a Roth IRA or to roll over or convert a regular IRA to a Roth IRA.

2. Contributions

A Roth IRA is an individual retirement plan. No deduction is allowed for contributions to a Roth IRA. This rule applies without regard to whether the owner of a Roth IRA is an active participant in an employer-sponsored plan.

An individual can make an annual nondeductible contribution to a Roth IRA of the lesser of $2,000, or 100% of the individual's annual compensation. Contributions to all of an individual's IRAs for any tax year cannot exceed $2,000.

There are limits on how much a taxpayer can contribute to a Roth IRA based on the taxpayer's AGI. These limits apply to all taxpayers regardless of whether they are active participants in an employer-sponsored qualified plan.

Married taxpayers can contribute the full $2,000 if their AGI is $150,000 or less. Single taxpayers can contribute the full $2,000 if their AGI is $95,000 or less. Contribution that can be made to a Roth IRA are phased out for joint filers with AGI between $150,000 and $160,000 and for individuals with AGI of between $95,000 and $110,000.

Example #1

John is a single taxpayer who in 1998 has earned income in the amount of $50,000 and an AGI of $75,000. John is covered under his employer’s pension plan. Although John cannot contribute to a regular deductible IRA, he can contribute up to $2,000 into a Roth IRA.

Contributions to a Roth IRA may be made even after the individual Roth IRA owner has reached age 70-1/2. Contributions to a Roth IRA for a tax year can be made no later than the time for filing the individual's return for that year (not including extensions).

This means that contributions to a Roth IRA for a tax year must be made on or before April 15 of the next tax year.

3. Rollovers to a Roth IRA

No rollover contribution may be made to a Roth IRA unless it is a qualified rollover contribution. A qualified rollover contribution is a rollover to a Roth IRA from either another Roth IRA, or from a regular IRA. There is no requirement that the entire amount of any distribution from an IRA be rolled over. A distribution which is partially rolled over within 60 days after the receipt of the distribution is OK as well.

A tax-free rollover from an IRA into another IRA may be made only once during any one-year period. This rule applies separately to each IRA an individual owns. A distribution from an IRA that is required under the minimum distribution rules cannot be rolled over to another IRA (regular nor Roth).

A taxpayer may not make a qualified rollover contribution to a Roth IRA from a regular IRA (or convert a regular IRA to a Roth IRA) during any tax year if (1) the taxpayer's adjusted gross income for the tax year exceeds $100,000, or (2) the taxpayer is a married individual filing a separate return.

Any amount includible in a taxpayer's gross income as a result of a qualified rollover contribution is not included in AGI for purposes of determining a taxpayer's eligibility to make that qualified rollover contribution.

Example #2

John, a single taxpayer, has an AGI of $75,000 before taking into account any income from rolling over the amount in his regular IRA to a Roth IRA.

He has $50,000 in a regular IRA that he wants to roll over to a Roth IRA. The entire $50,000 is attributable to deductible contributions to, and earnings of, the regular IRA. If the rollover is made, the $50,000 in the regular IRA will be included in John's gross income for tax purposes but not for purposes of determining whether he can make a qualified rollover contribution to a Roth IRA.

The amount from a qualified rollover contribution is includible in income in the year the rollover contribution is made to the extent that the amount consists of deductible contributions to, and earnings of, a regular IRA.

Nondeductible contributions to a regular IRA are not included in a taxpayer's income when rolled over to a Roth IRA. The 10% early withdrawal penalty does not apply to qualified rollover contributions to a Roth IRA from a regular IRA.

If all, or any part of a regular IRA is rolled over to a Roth IRA in a qualified rollover contribution during 1998, the amount required to be included in gross income as a result of that rollover contribution must be included in gross income ratably over the four tax-year period beginning with 1998.

This means that for qualified rollover contributions made in 1998, taxpayers will have a four-year period in which to pay the tax liability resulting from the rollover. This rule of spreading out the income from a 1998 rollover or conversion over four tax years is mandatory, not elective.

Example #3

In John’s example above, if he makes the $50,000 rollover contribution from his regular IRA to a Roth IRA in 1998, he will have to include in his AGI $12,500 per year during 1998, 1999, 2000 and 2001.

If a 1998 distributee of a qualified rollover contribution dies before the year 2001, all remaining amounts must be included in gross income for the tax year which includes the date of death.

However, if the spouse of such a distributee acquires the Roth IRA to which the qualified rollover contribution is properly allocable, the spouse may elect to include the remaining amounts in the spouse's gross income in the tax years of the spouse ending with or within the tax years of the deceased individual in which the amounts would otherwise have been includible.

The conversion of a regular IRA to a Roth IRA is treated as a rollover distribution from the regular IRA to the Roth IRA. This means that the rules for rollovers from a regular IRA to a Roth IRA also apply to conversions of a regular IRA to a Roth IRA.

Thus, a conversion may not be made in a year in which a taxpayer's AGI is more than $100,000, and income would have to be reported by the taxpayer to the extent that income would have to be reported if the total amount in the converted IRA were rolled over in a qualified rollover distribution.

A conversion of an individual's regular IRA can be made in a variety of ways without the individual taking a distribution. For example, an individual may make a conversion simply by notifying the IRA trustee. Or, an individual may make the conversion in connection with a change in IRA trustees through a rollover or a trustee-to-trustee transfer.

4. Distributions

Any “qualified distribution” from a Roth IRA is not includible in gross income. To be a qualified distribution, the distribution must be made on or after the date the individual becomes 59-1/2, or made to a beneficiary (or to the estate of the individual) after the individual dies, or attributable to the individual becoming disabled, or for a qualified special purpose distribution which means a qualified first time home buyer expense.

However, even if one of the conditions specified above is met, a distribution is not treated as a qualified distribution if it is made within the five-tax year period beginning with the first tax year for which the individual made a contribution to a Roth IRA.

Example #4

John, age 57, makes a $2,000 contribution to his Roth IRA on April 15, 1999 for his 1998 tax year. John makes no other contributions to a Roth IRA. On January 5, 2003, John withdraws $3,150 from his Roth IRA (when he is over 59-1/2). Of the amount withdrawn, $2,000 is attributable to the original contribution, and $1,150 is attributable to earnings.

The entire withdrawal is a qualified distribution, and thus not includible in Mike's gross income, since it was not made within the five-tax-year period beginning with 1998, the first tax year for which a contribution was made to a Roth IRA, and it was made after John reached age 59-1/2. 1998 counts as the first year for which the contribution was made and the five-tax-year period ends on December 31, 2002.

The withdrawal of qualified rollover contributions before the exclusion date would result in a 10% early withdrawal tax. A 20% early withdrawal tax would be imposed on a qualified rollover contribution that is includible in gross income ratably over four tax years beginning with 1998 to the extent that any part of that qualified rollover contribution is distributed before the exclusion date.

Taxpayers should very seriously consider setting up different Roth IRAs for new contributions and for qualified rollover contributions. This would enable taxpayers to withdraw contributions not subject to an early withdrawal penalty before withdrawing qualified rollover contributions that would be subject to such a penalty.

Also, this would make it possible for a taxpayer who needed to make a withdrawal before the exclusion date of a qualified rollover contribution to withdraw a rollover contribution subject to a 10% penalty before withdrawing a rollover contribution subject to a 20% penalty.

The early withdrawal penalty (i.e. distributions prior to age 59-1/2) does not apply to distributions:

To a beneficiary on or after the owner's death;
Because of the distributee's disability;
That are part of a series of substantially equal periodic payments made at least annually for the life of the distributee or the joint life the distributee and the distributee's designated beneficiary;
To the extent the distributions do not exceed the amount allowable to the distributee as medical expenses paid during the tax year;
To unemployed individuals for health insurance premiums;
To pay higher education expenses;
To pay qualified first-time homebuyer expenses.

A “qualified first-time homebuyer distribution” is any payment or distribution received by an individual to the extent the payment or distribution is used to pay the “qualified acquisition costs” of acquiring the “principal residence" of a “first-time homebuyer.”

The first-time homebuyer can be the individual, a spouse, or any child, grandchild, or ancestor of the individual or spouse. The withdrawals eligible for “first-time homebuyer” treatment can not exceed $10,000 during the individual's lifetime.

Roth IRAs are not subject to the minimum distribution rules that require an owner of a regular IRA to start taking distributions from the IRA by April 1 of the calendar year following the year he or she reaches age 70-1/2. This means that no distributions are ever required to be made from a Roth IRA during the owner's lifetime.

Accordingly, the owner, if he or she so desires, can continue to build up the value of their IRA free of all income taxes for the benefit of their heirs. Estate taxes will have to be paid on the amount in the IRA when the owner dies (unless a surviving spouse is the beneficiary), but unlike amounts in a regular IRA, no part of the amount in a Roth IRA will be subject to tax as income in respect of a decedent.

RealTax professionals have the knowledge and expertise to help you decide if a Roth IRA is right for you. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.